Shedding Light on Market Power

According to many modern introductory economics textbooks, the presence of market power, the ability of a firm or group of firms to have a significant influence on prices, represents the failure of a particular market to allocate economic resources to society's best interests. Where isolated examples of capitalism's flaws arise, the textbook authors continue, a government frequently can intervene and provide better results than the market outcomes.1 Earlier economists were also concerned that firms possessing market power adversely affect market outcomes. They, however, believed that governments were more likely to be the source of, rather than the remedy for, market power. Further, they believed that the more distorting and costly forms of market power were those caused by government intervention.

An Illumination of Market Power

When firms face the same costs, competition among sellers drives the price of a good down to the production cost of the good, leading to zero economic profits for all competing firms. Any firm that sets the price for its good higher than the competitive price will not sell anything, because customers will go to the firms offering the lower, competitive price. If a firm is able to protect itself against competitive pressures from other firms, it could raise its price higher than the competitive price and secure positive profits for itself.

To take an example, consider Chris, who owns the only stained glass window shop in San Carlos. It costs Chris $100 to make a stained glass window. If he were to set his price at $100 per window, he could sell 10 windows every week. His revenues (10 × $100 = $1,000) would equal his costs (also 10 × $100 = $1,000), so he would get zero profits. If he were to set his price at $180 per window, he could sell 6 windows every week. In this case, his revenues (6 × $180 = $1,080) would exceed his costs (6 × $100 = $600), so he would get a profit of $480 per week.

As long as Chris's shop is the only place where the people of San Carlos can get a stained glass window, Chris will set his price at $180 because he wants his profits to be as high as possible. Chris's problem is that his profits make the stained glass business look attractive to other people. Let's suppose that another San Carlosian, Sheila, opens her own stained glass window shop and competes with Chris. She also has costs of $100 per window, but she sets a price of, say, $170 per window and so gets all of Chris's business. Chris might then lower his price to $150 to get the customers back, then Sheila would lower hers, and so on until both of their prices are as low as either is willing to go, $100 per window, just enough to cover the production costs. The only way for Chris to maintain positive profits, to possess market power, is to prevent other shops like Sheila's from entering the market.

There are three points to make about this scenario and the nature of market power. First, San Carlos as a whole is worse off if Chris is able to retain his market power and sell six windows at $180 each rather than selling ten at $100 each. Chris is better off, to the tune of $480 in profits. That $480 is matched by the additional $80 over the competitive price that each of Chris's six remaining customers must pay, representing a $480 loss for them.

Second, there are four customers a week who would be willing to buy a window for $100 but not for $180. Therefore, to these four customers a stained glass window is worth at least $100 (but less than $180). Suppose all four of them think a stained glass window is worth $130. If Chris's price were $100, then each of these customers would get a net benefit of $30 from buying a window. If the price is $180, these customers do not buy a window, and so are deprived of $120 (4 × $30) of value. Adding this to the $480 loss of the other six customers, and Chris's market power costs San Carlos's consumers $600, which is more than the $480 in profits that Chris gains. Chris's market power is a net loser for San Carlos as a whole.

Third, it is not necessary for Sheila to actually open a second shop to prevent Chris from raising his price above the competitive price. As long as Chris believes that as soon as he raises his price, Sheila or someone like her will immediately enter the market and take all of his business, he has no reason to charge a higher price in the first place.2 The implication is that even if there is only one firm in a given market, that firm does not necessarily possess market power. Market power can only exist if there are impediments, called "barriers to entry," that prevent new firms like Sheila's from entering a market and competing on equal terms with firms, like Chris's, already in the market.3 The types and sources of these impediments were examined by many early economists, and are the subject of the following sections.

Barriers Confronted by Classical Economists

Barriers to entry can be divided into two broad categories, those that completely prevent new firms from entering a market, and those that raise the costs of firms that enter a market. Economists from previous centuries concentrated more on the former, while in the twentieth century, increasing attention was paid to the latter. As we will see, the barriers discussed by the earlier authors tended to be ones that were imposed by governments.

For a more general discussion of monopolies, see George J. Stigler's essay, "Monopoly," in the Concise Encyclopedia of Economics.

The major barriers to entry confronted by classical economists were government licenses that granted a particular firm or group of firms the exclusive authority to be the only legal seller of a given product. These licenses commonly prohibited altogether any imports from foreign countries of the good in question, and limited the number of domestic producers to a handful or just one. Economists were well aware of the implications on price and production that accompanied these market interventions. In Book I, Chapter 7, paragraphs 26 and 27 of An Inquiry into the Nature and Causes of the Wealth of Nations (1904, first pub. 1776), Adam Smith lamented the results of government-licensed monopolies:

The monopolists, by keeping the market constantly under-stocked, by never fully supplying the effectual demand, sell their commodities much above the natural price, and raise their emoluments, whether they consist in wages or profit, greatly above their natural rate.

The price of monopoly is upon every occasion the highest which can be got. The natural price, or the price of free competition, on the contrary, is the lowest which can be taken, not upon every occasion indeed, but for any considerable time altogether. The one is upon every occasion the highest which can be squeezed out of the buyers, or which, it is supposed, they will consent to give: The other is the lowest which the sellers can commonly afford to take, and at the same time continue their business.

Jean-Baptiste Say, in Book I, Chapter 17 of A Treatise on Political Economy (1903, first pub. 1855), presented an essentially similar view of government-created monopolies as Smith, but reserved special grievances for companies given exclusive trading rights for goods from particular overseas lands. In paragraphs 119 and 120, he wrote that

A government sometimes grants to individual merchants, and much oftener to trading companies, the exclusive privilege of buying and selling specific articles, tobacco for example; or of trafficking with a particular country, as with India.

The privileged traders, being thus exempted from all competition by the exertion of the public authority, can raise their prices above the level that could be maintained under the operation of a free trade. This unnatural ratio of price is sometimes fixed by the government itself, which thus assigns a limit to the partiality it exercises towards the producers, and the injustice it practises upon the consumers: otherwise, the avarice of the privileged company would be bounded only by the dread of losing more by the reduction of the gross amount of its sales, in consequence of increased prices, than it would gain by their unnatural elevation. At all events, the consumer pays for the commodity more than its worth; and government generally contrives to share in the profits of the monopoly.

Later in the same chapter, Say wrote that these privileged trading companies received an exceptionally good and unjust deal from the government granting the privileges because, while in the home country the trading company was protected from competition from either domestic or foreign rivals, when buying abroad the trading company received the benefits from competition by being able to buy from a multitude of potential overseas producers.

But, admitting the advantage of buying cheap to be as substantial as it is represented, the nation at large has a right to participate in that cheapness; the home consumers ought to buy cheap as well as the company. Whereas in practice it is just the reverse, and, for a very simple reason: the company is not exempt from competition as a purchaser, for other nations are its competitors: but as a seller it is exempt; for the rest of the nation can buy the articles it deals in nowhere else, the import by foreigners being wholly prohibited. It asks its own price, and can command the market, especially if it be attentive to keep the market always understocked, as the English call it; that is, if the supply be just so far short of the demand, as to keep alive the competition of purchasers.

This analysis brings us to the point in question; are the gains of the privileged company, national gains? Undoubtedly not; for they are wholly taken from the pockets of the nation itself. The whole excess of value, paid by the consumer, beyond the rate at which free trade could afford the article, is not a value produced, but so much existing value presented by the government to the trader at the consumer's expense.

In paragraph 57, Say expressed a healthy cynicism about the political process that led to the granting of monopolies, and their implications on their cost to the society as a whole:

Who, then, are the classes of the community so importunate for prohibitions or heavy import duties? The producers of the particular commodity, that applies for protection from competition, not the consumers of that commodity. The public interest is their plea, but self-interest is evidently their object. Well, but, say these gentry, are they not the same thing? are not our gains national gains? By no means: whatever profit is acquired in this manner is so much taken out of the pockets of a neighbour and fellow-citizen, and, if the excess of charge thrown upon consumers by the monopoly could be correctly computed, it would be found, that the loss of the consumer exceeds the gain of the monopolist. Here, then, individual and public interest are in direct opposition to each other; and, since public interest is understood by the enlightened few alone, is it at all surprising, that the prohibitive system should find so many partisans and so few opponents?

Governments that were either not aware of or not terribly concerned about the higher prices and lower production that occur under monopolies could sell off a monopoly privilege for substantial revenue because of the high profits that could be generated by a firm with substantial market power.

A temporary form of monopoly granted by governments is the patent. Patents allow the innovator of a new good or production technique to have the exclusive right to it for a set number of years. After that time, other producers are allowed to produce the good or use the technique. The market power firms acquire through holding a patent results in higher prices and lower output just like other barriers to entry, but many classical and contemporary economists have defended patents as a reward system that generates incentives for innovation. They argue that the losses to society caused by the temporary market power that patents create is outweighed by the benefits derived from the additional inventions and improvements people develop in pursuit of the monopoly profits patents can impart.

Barriers Confronted by Twentieth Century Economists

The barriers to entry described above involve a government restricting competition by preventing any new firms from entering a market. Although government-licensed monopolies are less prevalent today than they were in Smith's or Say's time, current examples can be found readily—many large cities restrict the number of taxis that can operate on their streets, several American states strictly control the number and locations of casinos within their borders, and patent systems are pervasive throughout the western world. In the past century, however, economists have widened their focus on barriers to entry to include those that do not prevent new firms from entering a market, but instead raise the costs faced by new firms. This type of barrier allows the already-existing firm some degree of market power to set its price higher than the competitive price, but usually not as high as it could if rival firms were completely prohibited.

An example of this type of barrier to entry is what Ludwig von Mises, in Book IV, Chapter 16, paragraph 156 of Human Action (1996, first pub. 1949), termed a "local margin monopoly":

A local margin monopoly is characterized by the fact that the barrier preventing outsiders from competing on the local market and breaking the monopoly of the local sellers is the comparative height of transportation costs. No tariffs are needed to grant limited protection to a firm which owns all the adjacent natural resources required for the production of bricks against the competition of far distant tile works. The costs of transportation provide them with a margin in which, the configuration of demand being propitious, an advantageous monopoly price can be found.

Returning to San Carlos and Chris's stained glass window shop, suppose that there is a certain mineral additive that imparts an especially radiant color to stained glass. There is no good substitute for the additive, and the only place that additive is found within 500 miles of San Carlos is in Chris's backyard. The cost of digging up this additive is included in Chris's production cost of $100 per window. Also assume that if Sheila or anyone else in San Carlos wants to use the additive to make especially radiant stained glass windows, she would have to have it shipped in, and the transportation costs would raise her per window costs to $115. Because Chris has a local monopoly on the mineral additive and the additive is costly to transport to San Carlos, he can raise his price above his production cost, up to $115 (or $114.99, to make sure that Sheila cannot compete). He cannot raise his price above $115, because if he did Sheila would enter the market and the competition would drive the price down to her production cost, $115. Thanks to his controlling the local supply of an essential resource, Chris is able to collect some positive profits ($115 − $100 = $15 per window sold), although not as much as he could if Sheila was prohibited from competing altogether.4

Other barriers to entry that can raise the costs of firms entering a market are trademarks, brand names, and advertising. These are somewhat different from other entry barriers in that they come about as a result of spending on the part of a firm already in a market.5 The basic argument is that if a product becomes well-known and for whatever reason inspires a certain amount of brand loyalty from its consumers, then those consumers will be willing to pay more than the competitive price for the good, even if a cheaper alternative exists.

Mises expressed this idea in paragraph 120:

The reasons why the consumers value the contribution of [an endorsement or brand name] so highly are manifold. They may be: special confidence placed on the individual or firm concerned on account of previous experience; merely baseless prejudice or error; snobbishness; magic or metaphysical prepossessions whose groundlessness is ridiculed by more reasonable people. A drug marked by a trademark may not differ in its chemical structure and its physiological efficacy from other compounds not marked with the same label. However, if the buyers attach a special significance to this label and are ready to pay higher prices for the product marked with it, the seller can, provided the configuration of demand is propitious, reap monopoly prices.

In Book II, Chapter 6, paragraph 16 of Risk, Uncertainty, and Profit (1921), Frank H. Knight made a similar point, but treated the affinity a consumer feels for a particular brand as a more legitimate product characteristic than did Mises:

The other [variety of market power "significant in the modern economic world"] is the use of trademarks, trade names, advertising slogans, etc., and we may include the services of professional men with established reputations (whatever their real foundation). The buyer being the judge of his own wants, if the name makes a difference to him it constitutes a peculiarity in the commodity, however similar it may be in physical properties to competing wares. And the difference from physically equivalent goods may be very real, in the way of confidence in what one is getting.

If through a celebrity endorsement or a catchy jingle Chris can convince the people of San Carlos that his stained glass windows are better built than those of anyone else in town could build, then buyers of stained glass windows may become reluctant to buy windows anywhere else. To the extent that his customers are willing to pay extra for the perceived quality of his windows, Chris could raise his price above the competitive price.

This scenario assumes that the positive profits Chris could receive by generating market power are larger than the advertising costs of creating consumer loyalty toward his shop. Otherwise it would not be worthwhile for him to do so. It also assumes that it costs significantly less for Chris to maintain his reputation than it would cost Sheila to establish her own reputation and overcome the barrier to entry.

Since Knight and Mises wrote on the subject, many economists have come to the conclusion that the main impact of advertising is to improve rather than deter competition, by increasing the amount of information available to consumers. The competing theories on advertising can be found in George Bittlingmayer's essay, "Advertising," in the Concise Encyclopedia of Economics.6

Relative Impacts

What is more relevant here than the ultimate effect of advertising is that the types of market power that Knight and Mises identified as emerging from sources other than government intervention were of a different and lesser sort than the type created by government intervention. Barriers to entry that arise due to geographic considerations (transportation costs) or the spending decisions of the producing firms themselves (advertising, brand names, etc.) are only able to impute some additional costs to firms that want to enter a market. Barriers that completely prohibit new firms from entering typically arise on government authority.

The distinction is important for two reasons. First, the degree of market power afforded to firms by distance or brand loyalty is likely to be fairly limited. A firm possessing these types of market power still cannot raise its price so high that it becomes feasible for competitors to incur substantial transportation costs, or for loyal consumers to be enticed away from their normal brand to a significantly cheaper rival.

Second, market power arising outside of the government can be reduced outside of the government. Improvements in the speed, reliability, and safety of transportation lower transportation costs and force a holder of a local margin monopoly to bring his price closer to the competitive price. Development in communication technologies creates new opportunities to target potential customers and establish a new brand's identity. Market power bestowed by an act of government, on the other hand, can usually only be removed by another act of government.

Because of these two reasons, the losses to society from non-governmental market power are apt to be less severe and of shorter duration than the losses caused by government-supported market power.7 This is perhaps one consideration that led Mises to conclude, in Book IV, Chapter 16, paragraph 126 of Human Action that "The monopoly problem mankind has to face today is not an outgrowth of the operation of the market economy. It is a product of purposive action on the part of governments. It is not one of the evils inherent in capitalism as the demagogues trumpet. It is, on the contrary, the fruit of policies hostile to capitalism."

The concept of barriers to entry and its relevance to market power have been long known, but there is still no generally agreed upon definition of precisely what a barrier to entry is. Several definitions that have been proposed over the last forty years are provided in the introduction of Gilbert, Richard J., "Mobility Barriers and the Value of Incumbency," Handbook of Industrial Organization, Chapter 8, Elsevier Science Publishers B.V, 1989.

If there are other uses for the additive other than making stained glass windows, then it is possible that people in those other industries would bid up the price of Chris's land to get access to the additive. If the opportunity cost of not selling his land are taken into account, Chris's economic profits might still be zero.

It can be argued that trademarks are registered and enforced by governments, and so should fall under the category of government-imposed barriers to entry. However, trademarks are government licenses giving a firm exclusive use of certain names or symbols, not the exclusive right to produce a given product. As such, the usefulness of trademarks in establishing brand names is their relevant aspect here.

In the last few decades, game theorists have offered another potential source of market power, namely that existing firms will invest in enough excess capacity to drive market prices below a potential entrant's production costs if entry does occur. If the existing firm can make this threat credible, this should deter entry. See Avinash Dixit, "The Role of Investment in Entry Deterrence," Economic Journal, Volume 90, March 1980, pages 95-106.

In the most widely known recent antitrust case, the government's zeal to prevent market power has led to a lengthy and expensive prosecution of Microsoft, even though the government's own witness admitted that Microsoft's business practices have caused no present-day harm to consumers. This is a strange development given that the primary justification provided by current economists and legal scholars for antitrust legislation is to protect consumers from the costly effects of market power.

*Morgan Rose is a Ph.D. candidate in economics at Washington University in St. Louis, with research interests in industrial organization, corporate governance and economic history.

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